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Thursday, August 14, 2008

Tolerance for Risk

Many commentators tell us that we each have a certain level of tolerance for investing risk and that we should make choices that work for us. As long as we are all true to our feelings about risk, we can all be right, even if we make different choices. This is bunk.

Betting next week’s grocery money on a horse is dumb whether you have a risk-taking personality or not. Buying stocks with the house down payment that you’ll need in 6 months doesn’t make sense even if you’re comfortable with it.

The appropriate way to invest money depends mainly on when you’ll need it and for what purpose. How much of a risk-taker you are may determine what choice you make, but it shouldn’t. The larger the sum of money, the more important it is to be driven by rationality rather than feelings.

The examples involving crazy risks are easy to agree with, but the mistakes of being too conservative can be harder to accept. Investing retirement money you won’t need for many years in bonds just doesn’t make sense even if you’re a nervous investor.

Keeping emergency savings in cash in case of job loss or other financial emergency makes sense. Safe investments for money that you will need in the next few years make sense. Even designating a small slice of retirement savings to be in bonds in case of a huge financial emergency may be sensible.

But, once these things are taken care of, it is appropriate to invest long-term savings in riskier investments that have higher expected rewards. I would prefer to see people try to overcome irrational fears before giving up and accepting a future with very modest savings.

4 comments:

Personally, I think most people do not take enough risk with their money.

Actually most people do not even understand what is risky and why it is risky in the first place. In my opinion bank savings accounts that offer less than 2% interest are risky. Reason being that you are pretty much guaranteeing you'll lose money after inflation and taxes. Most people are lost on this.

If the average person has their capital decline in an equity mutual fund over a one year period they chalk that up to the fund being lousy. They have no concept of time vs. volatility vs. risk etc.

MG: Part of the problem is the word "risk". As it is used technically in the financial world, risk means volatility. But, this isn't the common use of the word "risk". Your example of the savings account illustrates this nicely. The fact that you'll lose out to inflation and taxes makes the savings account risky in the common sense. But, because this bad outcome is fairly certain, it is not risky in the technical sense. It's no wonder that most people are confused about investing.

In addition to the problems you point out, there is a further issue. A person's feelings towards risk (as in volatility) isn't static either. Most people become risk averse in bear markets (by funneling cash into money market accounts) and blind to equity risk in bull markets (equity funds do roaring business).

CC: I guess it's not too surprising that people like volatility when their stocks go up and don't like it when they go down. I guess it's the tendency to expect the near future to be like the immediate past that causes people to be least cautious when stocks are peaking.